Equity markets weathered a rise in geopolitical tensions during the second quarter…

Equity markets weathered a rise in geopolitical tensions during the second quarter, as all major global equity indices posted strong returns despite increased turmoil in the Middle East and continued conflict in the Ukraine. Macroeconomic data showed the U.S. economic recovery regained its footing after a disappointing first quarter, while easing measures announced by the European Central Bank (ECB) were also a welcome development. Meanwhile, signs that economic growth in China was stabilizing helped emerging markets rebound after a rough start to the year. For the quarter, the Standard and Poor’s (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned 5.23%, 5.12%, 2.05%, 4.09%, and 6.60%, respectively.

Large-capitalization stocks outperformed their small-capitalization counterparts during the quarter, but this trend began to reverse in June. We believe that continued economic recovery and increasing M&A activity in the U.S. should benefit domestic small-cap companies as the year goes on. Growth stocks just barely beat out value stocks for the quarter, allowing value to remain firmly ahead year-to-date. Within the Russell 1000 Index, Energy was the clear leader in terms of sector performance, followed by Utilities and Information Technology, while the Financials, Consumer Discretionary, and Industrials sectors lagged. This trend, if sustained, will create a difficult environment for ESG-focused portfolios that have limited exposure to the Energy sector.

…as the crisis in Iraq led to a spike in oil prices.

With volatility indicators continuing to hover near historic lows throughout the quarter, investor confidence has the potential of turning into complacency. While stimulative monetary policies adopted by central banks around the world have certainly helped reduce the potential for negative catalysts to disrupt markets, the fact remains that volatility has nowhere to go but up, even if only marginally. Unfortunately, familiar sources of volatility – geopolitical turmoil and instability in the Middle East – reared their ugly heads during the quarter, or at least reminded market participants that they haven’t gone away.

As the current crisis in Iraq intensified, oil prices spiked in June, however they retreated toward the end of the month following reports that the situation was coming under control. In the past, this might have coincided with a sell-off in equity markets and rise in volatility, but this time investors seemed to shrug it off. This was likely due to the fact that America has reduced its dependence on foreign energy and that investors perceive the conflict as being a short-term dislocation rather than a long-term risk to the supply of oil, thus concluding that the economic impact is likely to be minimal. Markets have been re-awakened to the real possibility of an oil shock, and this threat alone can increase volatility going forward. For now, markets are betting that the situation is likely to be controlled and will not impede global economic growth. At the same time, simmering unrest in the Ukraine lingered during the quarter. But with a relatively remote chance of escalating into a broader regional conflict, market participants again determined the economic impact on global growth is likely minimal, and equity markets marched upward with emerging markets posting an impressive come back.

Investors instead fixed their attention on improving U.S. macroeconomic data…

Rather than focusing on events happening abroad, investors instead fixed their attention on improving U.S. macroeconomic data, and put the first quarter’s negative GDP growth in the rearview mirror. A strong U.S. corporate earnings season provided support to equity markets as top-line growth re-accelerated and 71% of companies in the S&P 500 beat their earnings estimates. The labor market also continued to show signs of improvement with jobless claims, continuing their downward trend throughout the quarter. Following June’s Employment report, monthly payroll gains have now exceeded 200,000 workers for five consecutive months, and the unemployment rate is now down to 6.1%, the lowest level since September 2008. A string of other macroeconomic data pointed to a second quarter rebound as well – auto sales continued to rise, Manufacturing PMI remained firmly in expansion territory, and consumer confidence edged up. The housing market recovery, an important driver of economic growth, also got back on track during the second quarter with data indicating a pick-up in housing activity which had been suppressed by the harsh winter weather. Despite this spate of positive U.S. macroeconomic data, one area of concern was sluggish consumer spending, which is likely being held down by low wage growth. However, we believe that U.S. economic growth will accelerate in the coming quarters, allowing for income growth which should boost both consumer confidence and spending.

…while the ECB announced easing measures…

In Europe, ECB president Mario Draghi announced a series of easing measures at the ECB’s June monetary policy meeting with the goal of stimulating growth and fending off deflation. In addition to cutting its main interest rate and imposing a negative interest rate on banks for their deposits, the ECB also introduced another round of long-term refinancing operations (LTRO) which the ECB will use to lend to banks at low rates thereby injecting liquidity into the lending markets. The hope was that this will spur greater lending to households and non-financial corporations. This came on the heels of weaker data in the eurozone as inflation dropped to 0.5%, the lowest since autumn 2009, and the euro area’s Manufacturing PMI declined to the lowest level since November 2013, with notable declines in France and Germany. As we have anticipated, European economic recovery will take much longer to materialize than market consensus has indicated.

…and China’s economy showed signs of stabilizing.

China’s economy continued to exhibit signs of a slowdown, with first quarter GDP advancing at an annualized rate of 7.4% compared to the prior quarter’s 7.7% growth rate, although the broader economy appeared to be stabilizing toward the end of the second quarter. The China HSBC Manufacturing PMI jumped to 50.7 in June, entering expansion territory for the first time this year, and the China HSBC Services PMI recorded its highest level since January 2013. The improving economic backdrop in China also helped propel emerging market equities during the quarter. However, concerns regarding the global implications of a Chinese property-bubble burst are unlikely to abate in the near-term due to a combination of excess supply and inflated property values.

Outlook

We continue to believe that this economic cycle will be more protracted than usual given the depth and severity of the financial crisis that preceded it. Consistent with that, and recognizing that this protracted cycle will continue to be characterized by very slow rates of improvement, we think the U.S. economy has recovered and is now going through an expansion phase. What this may mean going forward is that economic growth may continue to be slower than usual for this stage in the cycle, but it should still prove robust. Concerns about growth in emerging markets, and geopolitical turmoil to the headlines have effectively injected more risk into markets, with investors taking a more cautious approach toward equities as a result. In the short term, this has been positive for U.S. treasuries, evidenced by their outperformance relative to stocks year to date, and bond-fund inflows compared to equity-fund outflows. However, from a longer-term perspective, bond prices are likely to come under greater pressure as the Fed continues to wind down its asset purchase program. The U.S. Federal Reserve will continue to focus on maintaining positive economic growth in the U.S. and is adjusting the pace of its QE tapering accordingly. As we have maintained for some time now, a key consideration in the Fed's strategy remains the U.S housing market, which is a chief driver of U.S. economic growth. In view of this, we do not believe we will see much interest-rate volatility in the near term. Having said that, time will continue to work against low rates as the long-term trajectory has nowhere else to go, but up.

This commentary represents the opinions of the author as of 7/7/14 and may change based on market and other conditions. These opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information. Calvert may have acted upon this research prior to or immediately following publication. In addition, accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.

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